In September 2015, the Office of the Comptroller of the Currency (OCC) published an updated edition of the Bank Accounting Advisory Series (BAAS),marking the 25th anniversary of the first edition that was published in 1990. Not only does the series provide valuable insight and advice on how to properly account for various banking situations (OREO, ALLL, acquisitions, etc.), the questions and answers included can help clarify when and why loans should be placed on nonaccrual or identified as a Troubled Debt Restructure (TDR). Assignment of these designations is often determined by lenders or the credit department, but the purpose is firmly based in, and determined for, proper accounting in accordance with Generally Accepted Accounting Principles (GAAP). In addition, the situations explained give guidance on methods to improve problem loans, such as note bifurcation.
Due to negative connotation, risk rating considerations, and adverse accounting treatment, TDR designation can often be a point of contention. The BAAS sets out to help clarify the issue (Section 2A – BAAS). Excerpts of questions commonly asked and particularly useful questions from the BAAS are included below. Refer to the full text for complete answers as well as additional questions.
Question 1 – “What is a TDR?”
Under GAAP, a modification of a loan’s terms constitutes a TDR if the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider. The concession could either stem from an agreement between the creditor and the debtor or be imposed by law or a court. Accounting guidance for TDRs is included in ASC 310‐40. Not all modifications of loan terms, however, automatically result in a TDR. For example, if the modified terms are consistent with market conditions and representative of terms the borrower could obtain from other sources, the restructured loan is not a TDR. If, however, a concession (e.g., below‐market interest rate, forgiving principal, or forgiving previously accrued interest) is granted based on the borrower’s financial difficulty, the TDR designation is appropriate.
Question 2 – “What are some examples of modifications that may represent TDRs?”
The following are some examples of modifications that may represent TDRs: • Reduction (absolute or contingent) of the stated interest rate for the remaining original life of the debt.
• Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk.
• Reduction (absolute or contingent) of the face amount or maturity amount of the debt as stated in the instrument or other agreement.
• Reduction (absolute or contingent) of accrued interest.
• Payment deferral Said another way, the modification is a TDR if the borrower cannot go to another lender and qualify for and obtain a loan with similar modified terms.
Question 3 – “If the modification is a TDR, is the loan impaired?”
Yes. TDR loans are impaired loans. A loan is impaired when, based on current information and events, it is probable that an institution will be unable to collect all amounts due, according to the original contractual terms of the loan agreement. Usually, a commercial loan that underwent a TDR already would have been individually evaluated and identified as impaired, with impairment measured under ASC 310‐10‐35. Loans whose terms have been modified in TDR transactions should be measured for impairment in accordance with ASC 310‐10‐35. This includes loans that were originally not subject to that standard before the restructuring, such as individual loans that were included in a large group of smaller‐balance, homogeneous loans collectively evaluated for impairment (i.e., retail loans).
Bifurcating notes is also addressed under the TDR section of the BAAS. Bifurcation, in relation to lending, is the practice of dividing existing debt into two parts, generally in an effort to improve payment performance, accounting, and risk rating of the transaction. See the following example included in the BAAS:
Facts – A $10 million loan is secured by income‐producing real estate. Cash flows are sufficient to service only a $9 million loan at a current market rate of interest. The loan is on nonaccrual. The bank restructures the loan by splitting it into two separate notes. Note A is for $9 million, is collateral dependent, and carries a current market rate of interest. Note B is for $1 million and carries a below‐market rate of interest. The bank charges off all of Note B but does not forgive it.
Question 9 – May the bank return Note A to accrual status?
Yes, but only if all of the following conditions are met: • The restructuring qualifies as a TDR as defined by ASC 310‐40. In this case, the transaction is a TDR, because the bank granted a concession it would not consider normally, a below‐ market rate of interest on Note B.
• The partial loan charge‐off is supported by a good faith credit evaluation of the loan(s). The charge‐off should also be recorded before or at the time of the restructuring. A partial charge‐off may be recorded only if the bank has performed a credit analysis and determined that a portion of the loan is uncollectible.
• The ultimate collectability of all amounts contractually due on Note A is not in doubt. If such doubt exists, the loan should not be returned to accrual status. • There is a period of satisfactory payment performance by the borrower (either immediately before or after the restructuring) before the loan (Note A) is returned to accrual status.
If any of these conditions is not met, or the terms of the restructuring lack economic substance, the restructured loan should continue to be accounted for and reported as a nonaccrual loan.
Question 10 – “What constitutes a period of satisfactory performance by the borrower?”
ASC 942‐310‐35 requires some period of performance for loans to troubled countries. The staff generally believes this guidance should also apply to domestic loans. Accordingly, the bank normally may not return Note A to accrual status until or unless this period of performance is demonstrated, except as described in question 11.
Neither ASC 942‐310‐35 nor regulatory policy, however, specify a particular period of performance. This will depend on the individual facts and circumstances of each case. Generally, we believe this period would be at least six months for a monthly amortizing loan.
Accordingly, if the borrower was materially delinquent on payments prior to the restructure but shows potential capacity to meet the restructured terms, the loan would likely continue to be recognized as nonaccrual until the borrower has demonstrated a reasonable period of performance; again, generally at least six months (removing doubt as to ultimate collection of principal and interest in full).
Question 11 – “The previous response indicates that performance is required before a formally restructured loan may be returned to accrual status. When may a restructured loan be returned to accrual status without performance?”
The staff continues to believe that evidence of performance under the restructured terms is one of the most important considerations in assessing the likelihood of full collectability of the restructured principal and interest. In rare situations, however, the TDR may coincide with another event that indicates a significant improvement in the borrower’s financial condition and ability to repay. These might include substantial new leases in a troubled real estate project, significant new sources of business revenues (i.e., new contracts), and significant new equity contributed from a source not financed from the bank. A preponderance of this type of evidence could obviate the need for performance or lessen the period of performance needed to assure ultimate collectability of the loan.
To restore a nonaccrual loan that has been formally restructured in a TDR to accrual status, an institution must perform a current, well‐documented credit analysis supporting a return to accrual status based on the borrower’s financial condition and prospects for repayment under the revised terms. Otherwise, the TDR must remain in nonaccrual status. The analysis must consider the borrower’s sustained historical repayment performance for a reasonable period prior to the return‐to‐ accrual date, but may take into account payments made for a reasonable period prior to the restructuring if the payments are consistent with the modified terms. A sustained period of repayment performance generally would be a minimum of six months and would involve payments in the form of cash or cash equivalents.
Six months appears to be a firm regulatory standard for proven payment performance to return loans to accrual (barring other, adverse information), based on the BAAS advice and FIL‐50‐2013. In practice, the six month payment performance timeframe is often used to justify upgrading the risk ratings of loans that have previously been criticized or classified. As detailed below, the FIL confirms that, when appropriate, a TDR frequent, but not always, warrants an adverse rating and that risk rating can and should be reconsidered when appropriate:
…a TDR designation does not automatically mean that a loan should remain adversely credit risk graded or classified for its remaining life if it already was or becomes adversely credit risk graded or classified at the time of the modification. A TDR loan should be adversely credit risk graded or classified if the loan, as modified, is inadequately protected by the current sound worth and paying capacity of the borrower or the collateral pledged, if any. In determining the credit risk grade or classification of a TDR loan at the time of a modification or at a subsequent evaluation date, a well‐ documented assessment of the cash flows available to service the modified loan and the extent of any collateral protection and guarantor support should be performed to form the basis for determining whether an adverse credit risk grade or classification is warranted.
The OCC provides additional TDR guidance in Bulletin 2012‐10 in regard to the duration that a restructured loan must continue be reported as a TDR:
III. Once a TDR, always a TDR?
Generally, until a loan that is a TDR is paid in full or otherwise settled, sold, or charged off, the loan must be reported as a TDR. However, the reporting (disclosure) of a loan as a TDR is a separate analysis from whether the modification must continue to be evaluated under ASC Subtopic 310‐10.
A loan that is a TDR that has an interest rate consistent with market rates at the time of restructuring (for example, the A note in an A/B note split structure) and is in compliance with its modified terms need not continue to be reported (disclosed) as a TDR in calendar years after the year in which the restructuring took place, in accordance with ASC Subtopics 310–10–50–15(a) and 310–10–50–15(c). To be considered in compliance with its modified terms for call report purposes, a loan that is a TDR must be in accrual status and must be current or less than 30 days past due under the modified repayment terms…
In October 2009, the OCC issued ‘Policy Statement on Prudent Commercial Real Estate Loan Workouts’ also offers advice regarding classification, accrual treatment, and TDR treatment with various scenarios given for examples. Scenarios address issues above such as note bifurcation and when loans may no longer be reported as a TDR.